Goodwill, Blue Sky, Pie in the Sky, all the same!

3 08 2012




Wait a minute there is a huge difference.  Assume for instance you are a famous scientist that just made a machine that would make pure gold and the cost of the machine was $20,000. How much would someone pay for this machine. I am willing to bet it would be more than $20,000. But how much more, is the Appraisers dilemma.  Well the first thing to decide is how much production is it capable of and secondly how long will the machines run. All machines need maintenance and surely as sophisticated as this one is, what will that cost?


 Where will we get the parts, are they available and how expensive would they be? Who is qualified to repair this machine? Is the inventor the only one who could fix it? How long will this genius be around and what will he charge for consulting or repair?  Oh no, what if this ability to make pure gold is illegal and if not how 


long before Uncle Sam decides you are ruining the economy and passes 


laws to stop your production? But wait, maybe they would want to buy 


it. Oh my God, how much more would Exxon pay? Forget Exxon, what about 


Germany, no wait, the Chinese or Russians? However, the Saudi’s have 


all the cash. Hmmmmm


 I wonder what the value of this machine is now.  I would bet millions or even billions. What do we call this increase in value? Is this blue sky?  Is this increase in value really real?  Surely not, since the SBA is only willing to loan $20,000 plus one half of this so called blue sky, and not to exceed $250,000.  Maybe with this thinking a buyer should forget this machine as it is obviously risky with all that goodwill and purchase another machine that only has cash flow that will support a loan of $40,000.


 I think you can see by this silly scenario that there is goodwill. A business should be looked at the same as a money machine.  The appraiser needs to study the company to find its strengths and weaknesses and calculate risk. Based on its current operation what does the future hold for this business? Will future government regulation slow down or end the cash flow?  What about the company’s suppliers, is cost going to increase; is there other suppliers the company can buy from or are is the company at the mercy of a single supplier. As stated above, all machines need repair, so what kind of condition is the equipment in and how old is it.  Does the seller have a good reason for selling his or her business? How hard will it be for a new owner to fill his shoes?  It’s good to hear that the workforce has been with the company for years with hardly no turnover and that these excellent employees and managers made the company grow throughout the years, but what is the age of the employees and management?  Are they all going to retire soon? When was their last raise?




Just who are the company’s customers?  Is that one big account that represents over 50% of their business going to buy from the company through ownership change; and are they under contract to buy; or is the customer’s CEO a long time college buddy of our retiring seller?


 Another factor in calculating risk is the economy and the company’s trade area.  Based on the foreseeable future, is the company’s product or service going to be negatively affected? 


 Salaries and wages are usually the second largest expense after cost of goods. Considering the nature of the business and the degree of technical expertise needed to make the company’s products; is the new owner likely to find new people to replace retiring employees and management; and what will they have to pay them? A shortage of talent is like everything else, the more scarce, the more you have to pay.  Being the second largest expense, and not able to project future costs, means any projections are guesswork, and as we all know, anticipated future earnings is the foundation of all valuation models.


 Value has a lot to do with the size of the buyer pool. Is this company such that the technical expertise needed to manufacture, improve, market, and upgrade its product such that only a handful of buyers are qualified; or would it be a perfect fit for the thousands of unemployed managers from corporate downsizing.


 Ease of entry plays a big part in value. How hard is it to start up and compete with this company?  If you are successful, one certainty in business you can count on is your neighbor will be selling a close substitute product or worse; one of the huge companies with millions to spend on advertising and marketing will shut you out of the market completely.  If a buyer can open up across the street from the business and make as much money in six months to a year, why would the buyer pay 4 or 5 years of earnings. However, if the buyer was looking at a substantial upfront investment in assets and a 5 hard years to get where the owner is now; knowing he would be constantly shelling out his personal capital to keep his new start up business afloat and receiving no salary during those 5 years, would realize he would be way ahead by paying the 5, 6 or maybe 7 years of earnings because he would start making money the first month, receiving a salary and does not have to compete with the company.


 Every question in this article must be assigned a degree of risk.  The compilation of these risk factors determines the capitalization rate or multiple of earnings used to establish the value of the company and determine its goodwill.  


The Small Business Administration (SBA) defines goodwill as:


 “Goodwill” is created when an existing business is acquired and the acquiring entity pays more for the business than the book value of the business’s assets.  Simply put, “goodwill” is the premium the seller is requiring as part of the purchase price (and the buyer is willing to pay) for an established business in the marketplace as compared to that same buyer starting a new business.  By paying a premium for an established business, the buyer is relying on the existing business’s established market share to continue due to such reasons as an established customer base, a premium location, etc.  (Customer lists and non-compete agreements are documents that the seller may provide to support the goodwill the seller is requesting.) 


Therefore, simply stated, it is the difference between what a company will sell for and it’s hard assets.  To get to the price the company will sell for, the appraiser has researched, analyzed, compared prior sales and analyzed a myriad of factors that would contribute to or decrease value.  In the Excess Earnings method, each asset of the business is analyzed as to the return it should earn.  The amount of earnings after this is considered excess and is capitalized to calculate goodwill.


In summary, there is a huge difference between goodwill, blue sky, and pie in the sky, because goodwill is painstakingly analyzed, researched, compared to comparable sales and calculated.  Blue Sky and Pie in the Sky are values that are guessed at or just pulled out of thin air so the next time you hear someone using them interchangeably I hope you will correct them.





Comparing Comparables

3 08 2012

Comparing Comparables 

By: George D. Abraham CEO & Chief AppraiserImage

Business Evaluation Systems  

The Direct Market Data Method (DMDM) relies on the principle of substitution. A buyer will not pay more than the price at which he can obtain an equally desirable substitute.


The DMDM method uses parameters of comparison in the form of income multipliers.  They can be multipliers of income, either gross net or discretionary cash flow.  The three most popular databases which supply the transactional data are; Institute of Business Appraisers (IBA), BizComps and Pratts Stats.


When attempting to value a company using the Direct Market Data Method (DMDM), it is not uncommon to experience a wide range in value between the Price to Discretionary Earnings (P/E) and Price to Sales (P/S). In using the transactional data, one must remember that we are comparing businesses and in most cases, these are complex entities.  Unlike real estate, whereby land and improvements can be measured fairly accurately using a comparison of price per square foot, businesses are much more complex and have many variables that can have a significant impact on value. There are several reasons for the wide ranges that occur between the two multiples when using the databases.


The three databases obtain their data mainly from business brokers and other intermediaries.  The reporting systems for each of the databases are not standardized and some are limited regarding details of the transactions. The fundamental problem in collecting data is the reporting forms supplied to collect the data.  Business sale structures can be very complex, forcing the broker to elaborate on the form in order to describe the input, especially when it comes to the selling price.  Many sales contain exchanges, earn-outs or an additional price based on some contingency and forces the business broker to elaborate when the reporting the selling price of the business. The person inputting the data into the database is faced with deciding the selling price.   Unfortunately, the industry lacks consistency in common terms such as owner’s discretionary cash flow and net income (before or after tax).  The BizComps database removes the inventory from the selling price, but many times sales include inventory and is not mentioned or if mentioned, no inventory value is given.  Inventory values given to the other databases and included in the price, have usually not been valued or even counted for accuracy. In my experience, the Sellers value of the inventory is almost always incorrect as it does not include adjustments for slow moving, never moved or dead inventory. Adding to the dilemma on inventory is FIFO and LIFO accounting.


The sales contained in the databases were sold as asset sales and generally do not include current assets or liabilities, but many times to make the sale, the owner will include the receivables and/or allow the buyer to assume some of the liabilities.


Another problem with reporting the sales consistently are real estate and improvements.  Companies in the databases do not include real estate and improvements and a fair market rent has been deducted from the company’s earnings, but was the rent used really fair market?


Location of business is given only in terms of general geographic area which could have a significant effect on value for some businesses whereby location is paramount to success.


In other cases, the sales with high multiples are not arms length and the business was purchased based on acquiring a valuable location or a competitor paying over market value to eliminate a major competitor.  As many Baby Boomers are retiring, they are transferring the businesses to sons and daughters and these may also not be at arm’s length.

Another problem, which in my mind is significant, is that prior revenues and earnings are not provided. Without a history of the company’s historical performance we do not know if the Company was in rapid decline or significantly increasing in revenues and earnings. Despite the reporting problems inherent in the databases, if analyzed correctly, the data is very valuable. The least it can do is set a range of multiples that you can narrow down. 

Business appraisers will sort the sales in the databases according to revenues and then choose a group which contains sales that are close to the company or a sales range which would not change the operating ratios significantly.  Once the comparable group is established, the companies in the group need to be carefully analyzed to their closeness to the subject company.  Companies whose sales to earnings ratios are significantly different than the subject should be discarded. A close look at the location should be made if that is important and the date sold.  I think it is safe to say that most people feel that there was a world of difference in business after the beginning of 2009.  However, before you form this conclusion in your analysis, take into consideration that all values are derived from anticipated future performance.  As we all can remember, interest rates were extremely high back then and required return on investment had to compensate for this, this and the higher the return required, usually the lower the value.  Currently interest rates are at an all time low and the required return is much lower so in some cases the older sales may not be that different.



EBITDA Pro’s and Con’s

1 02 2011

EBITDA Pro’s and Con’s

By: George D. Abraham

Business Evaluation Systems


EBITDA, an acronym for “earnings before interest, taxes, depreciation and amortization”, is an often-used measure of the value of a business.

EBITDA is calculated by taking operating income and adding depreciation and amortization expenses back to it. EBITDA is used to analyze a company’s operating profitability before non-operating expenses (such as interest and “other” non-core expenses) and non-cash charges (depreciation and amortization).

Critics of EBITDA claim that it is misleading due to the fact that it is often confused with cash flow and factoring out interest, taxes, depreciation and amortization can make even completely unprofitable firms appear to be fiscally healthy.  Looking back at the dotcom companies, there are countless examples of companies that had no hope, future or earnings and the use of EBITDA made them look attractive.

Also, EBITDA numbers are easy to manipulate.  If fraudulent accounting techniques are used to inflate revenues and interest, and taxes, depreciation and amortization are factored out of the equation, almost any company will look great. Of course, when the truth comes out about the sales figures, the house of cards will tumble and investors will be in trouble.  In the mid-nineties when Waste Management was struggling with earnings, they changed their depreciation schedule on their thousands of garbage trucks from 5 years to 8 years. This made profit jump in the current period because less depreciation was charged in the current period. Another example is the airline industry, where depreciation schedules were extended on the 737 to make profits appear better. When WorldCom started trending toward negative EBITDA, they began to change regular period expenses to assets so they could depreciate them. This removed the expense and increased depreciation, which inflated their EBITDA. This kept the bankers happy and protected WorldCom’s stock.

Another concern is that EBITDA does not take into account working capital. It could be helpful to also point out that EBITDA is not a generally accepted accounting principal.

Because EBITDA can be manipulated like this, some analysts argue that a it doesn’t truly reflect what is happening in companies. Most now realize that EBITDA must be compared to cash flow to ensure that EBITDA does actually convert to cash as expected.

To sum up the cons:


1. EBITDA ignores changes in working capital and overstates cash



2. EBITDA can be a misleading measure of liquidity.


3. EBITDA does not consider the amount of required investment.


4.  EBITDA ignores distinctions in the quality of cash flow resulting

from different accounting policies.


5. EBITDA deviates from the GAAP measure of cash flow because it

fails to adjust for changes in operations-related assets and


On the plus side, EBITDA makes it easier to calculate how much cash a company has to pay down debt on long term assets. This calculation is called a debt coverage ratio. It is calculated by taking EBITDA divided by the required debt payments. This makes EBITDA useful in determining how long a company can continue to pay its debt without additional financing.

Overall, EBITDA is a stripped down, uncomplicated look at a company’s profitability. It eliminates the subjectivity of calculating amortization and depreciation. Depreciation and amortization are unique expenses. First, they are non-cash expenses – they are expenses related to assets that have already been purchased, so no cash is changing hands. Second, they are expenses that are subject to judgment or estimates – the charges are based on how long the underlying assets are projected to last, and are adjusted based on experience, projections, or, as some would argue, fraud.

EBITDA takes out interest which is a result of management’s choices of financing. And, it removes taxes which can vary greatly depending on numerous situations